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Bright Spots for Snap (and More Dark Ones, Too)

It isn't all bad news, all the time for Snap...but it’s a lot of bad news, a lot of the time, and this quarter was no different.

Snap (NYSE:SNAP) stock popped big following the release of the Snapchat operator's fourth-quarter earnings, and there were definitely some good numbers and trends in the report. But even then, the company has some serious problems.

In this segment from Industry Focus: Tech, analyst Dylan Lewis and Motley Fool contributor Evan Niu discuss a few of the bright spots in Snap's report -- like increased gross margin and cost savings -- and explain why the company's decreased spending isn't as much of a win as it might seem.

A full transcript follows the video.

This video was recorded on Feb. 23, 2018.

Dylan Lewis: If you're looking for bright spots in some of the recent numbers that we've seen from Snap, I think you can look at gross margin and say, we're kind of pleasantly surprised with the expansion that we've seen there. You look at revenue and cost on a per-user basis, and of course, the company backs out some costs like stock-based comp, depreciation and amortization, but, Snap posted a gross margin of 36% in the most recent quarter on a per-user basis, and that's up from single digits in early 2017. Which is pretty impressive to me.

Evan Niu: Right. They're definitely making a lot of progress there on the cost side as well, kind of like Twitter but not in the same way. Snap, as we've talked about many times before, their biggest cost is the hosting cost they pay to Amazon Web Services and Google Cloud. Google is their biggest cloud infrastructure provider. But, they've been able to leverage this dual relationship to pit these two companies against each other if they negotiate and score some pricing concessions, which helps them on the cost side. That's helping and really contributing to this gross margin expansion, because they're able to keep these costs in check while the ad business is growing, and they are making some definite progress on that side, too. They're really shifting to this programmatic self-serve ad platform. 90% of ads purchased last quarter were done so programmatically. Which is better for scaling, better for costs. So, there are some things that they are doing that they're making progress on.

But I still think this hosting cost strategy is terrible in the long term. If you look at it, they spent almost $500 million in 2017 on hosting costs alone, and about $85 million on capital expenditures. So, they're spending so much money for something that, they're just renting this capacity as opposed to owning it. Generally, any time you rent something, you don't have anything to show for it afterwards. And they argue that their low capex helps their free cash flow, which is technically true, but even with this capital-light model, they've burned over $800 million in negative free cash flow last year, mostly because operating cash flow is negative. They burned $180 million a quarter on average in operating cash flow last year. So, it's hard to really believe their argument that this is the right strategy.

Lewis: Yeah, it's a bold strategy. We haven't really seen too many tech companies of their size try things this way, where they have basically variable costs for hosting that are going to fluctuate with how much people are using it. It makes that leverage you were talking about a little bit tougher to reach.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of GOOGL and AMZN. Evan Niu, CFA has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends GOOGL, GOOG, AMZN, and TWTR. The Motley Fool has a disclosure policy.